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Saturday, 28 November 2015

Douglass C. North, one of the greatest economists of our time, a Nobel prize winner responsible for reinventing institutional economics, died this week at the age of 95. His passing follows those of other notable institutional and political economists in the past few years, such as Elinor Ostrom, James Buchanan, Ronald Coase, and his Nobel co-recipient Robert Fogel, all champions of the new approach to examining economic interactions, and all, just like North, with groundbreaking contributions to the field. Together with Olivier Williamson and Ronald Coase, he was attributed as the pivotal co-founder of the New Institutional Economics school of thought, a school of thought I personally favor and advocate.

Out of all academics North arguably led the most exciting life. He was a navigator for the US Merchant Marines during WWII, a passionate photographer, a deep-sea fisherman, an heir to an insurance fortune, a pilot (he had his own plane), a ranch owner, fancied fine dining and music - in short, a man who enjoyed life (read his detailed autobiography here). A Marxists in his youth ("as were many of us at a certain age", as Deirdre McCloskey put it), he changed his political economy standpoints after studying economics, political science and philosophy at the University of California, Berkeley, where he also received his PhD in economics. In 1952 he became an assistant professor at the University of Washington, while in 1983 he moved to Washington University in St Louis, where he remained throughout the rest of his career.

Cleometrics and the buildup to the examination of institutional change

North's contributions to economics and in particular economic history are monumental. His first big contribution came in the 1960s where he helped found cliometrics, an application of quantitative techniques in the study of history (named after the mythological Clio, the muse of history). His first book The Economic Growth of the United States from 1790 to 1860 had the transformative influence on the field of economic history. In his own words, "it was a straightforward analysis of how markets work in the context of an export staple model of growth." Throughout that decade North was focused on transforming economic history into cliometrics, something he proved to be very successful at, organizing conferences and even a graduate program in economic history at the University of Washington in the early 70-ies.

Interestingly, his work at the time on cost reductions in the shipping industry turned him towards examining transaction costs and institutions. He realized that the neoclassical theory is too restrictive on its assumptions over zero transaction costs and exogenous, efficient institutions. So he went on to change that as well: “What we need is a body of theory which encompasses the traditional models of the economist and both widens its scope and allows us to include an explanation of the formation, mutation and decay of organisational forms within which man cooperates or competes.”

Institutions thus became the forefront of his research from thereon. In particular he focused on how and why institutions change and evolve over time, and he did it all within the realms of neoclassical theory. It was the perfect way to combine history and economics. By many his best book Structure and Change in Economic History (1981) came as a result:

"In Structure and Change in Economic History (1981) I abandoned the notion that institutions were efficient and attempted to explain why "inefficient" rules would tend to exist and be perpetuated. This was tied to a very simple and still neo-classical theory of the state which could explain why the state could produce rules that did not encourage economic growth. I was still dissatisfied with our understanding of the political process, and indeed searched for colleagues who were interested in developing political-economic models."

From here also follows his criticism of neoclassical economics in that it cannot explain all the factors necessarily for the understanding of the extremely complex process of economic change. He argued that political systems do not design institutions that promote growth, quite the contrary. Because of high transaction costs in the process of changing the political status quo, political elites lack the motivation to do it. They become entrenched in a low equilibrium, happy with their current levels of rent-extraction, and perfectly unwilling to initiate the process of institutional change that would be beneficial to their societies.

To further understand why this is the case, North started to examine a system of beliefs and social norms, or in other words - informal institutions.

Institutions

In that search for answers to explain the process of institutional change, another monumental piece was published, Institutions, Institutional Change and Economic Performance (1990), in which North for the first time very precisely defines what institutions are. In his own words:

“Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction...Institutional change shapes the way societies evolve through time and hence is the key to understanding historical change.” (North, 1990, pg. 3)

He furthermore makes a very important distinction in defining formal and informal institutions. Formal institutions represent the aforementioned "rules of the game": rule of law, enforcement of contracts, property rights and the constitution. Their goal is to promote political stability and ensure the proper functionality of markets. The complete implementation of such institutional arrangements will lead to a good and stable political system. Informal institutions, on the other hand, imply social norms, traditions, customs and code of conduct. They are embedded in a person’s mentality and system of beliefs and will influence the nation’s view on the optimal political system.

Informal institutions can provide an explanation of why the system fails to consolidate even when there exists a set of formal institutions. More importantly it will tell us why this set of formal institutions will still yield inefficient results if set up in a system of values not ready for democracy, or whatever social system we are envisioning. Informal institutions don’t change overnight as do the formal institutions and laws; rather they accumulate over time and by doing so form the necessary conditions for the formal institutional reforms to yield efficient results. However, the relationship between them is mutual. A continuous influence of formal institutions tends to be a prerequisite for a proper reshaping of informal institutions.

Although a substantial amount of variables that differ across countries affect how its citizens will feel about a particular political system and the proper institutional setting, an assumption is that whatever affects them, informal institutions are unlikely to be changed in the course of a single generation. Due to this characteristic they might be a constraining factor once a rapid change of formal institutions occurs. On the other hand they might also enhance a democratic order but only in the long run and always followed by a long and gradual accumulation of democratic capital. A positive influence can be generated if informal institutions are changing long enough (under the influence of pro-democratic formal institutions) so that they become widely accepted social norms. The example is the length of democracy in the West where a long and continuous democratic tradition embedded on the assumptions of pro-democratic formal institutions generated a spontaneous change of informal institutions.

All of these findings and efforts landed North the Nobel prize in economics in 1993, jointly with another brilliant economic historian Robert Fogel. Officially they were rewarded "for having renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change". Read his Nobel prize lecture here.

Violence and Social Orders

As Arnold Kling has put it, there is no other Nobel laureate that has produced anything as good as his book Violence and Social Orders (co-authored with Wallis and Weingast), after receiving the prize (read Kling's excellent review here). It is truly remarkable that a man in his late 80-ies/early 90-ies can produce such an astonishing piece of work (and if you're doubting the scope of his contribution just hear him give this interview three years ago).

The central theme of the book is to offer a comprehensive theory of a society's institutional development with respect to how it reacts to and deals with the problem of violence. The authors present an institutional framework in which well-organized ruling elites manipulate the economy by generating privileges based on the personalization of governing institutions. They define such societies as natural states, or the more precise limited access orders, in which intrapersonal relationships between the powerful and the political elites serve as the base of all political and economic outcomes. The elites are then successful in preventing the development of the civil society and ensure a long-run constellation of existing political relationships. When the institutions of a system are de-personalized it is much harder to evoke clientelistic relationships, making it easier to develop an open access order. In an open access order, the basis of all interactions is a well-defined, de-personalized legal framework, not politically generated privileges, and it is only through such a system that countries can achieve prosperity. I wholeheartedly recommend not only this book, but the majority of his scientific opus.

Here, as always, is a list of North's most important publications:

The Economic Growth of the United States, 1790–1860, Prentice Hall, 1961.

"The State of Economic History," American Economic Review, 55(1/2) 1965.